Net Present Value (NPV) Calculation Example
The NPV method is based on the time value of money principle, which states that money is worth more today than it will be in the future. This is because money can earn interest, and the longer you have to wait for the money, the less you will get in return.
The Net Present Value (NPV) method is a business investment decision-making tool. It is a discounted cash flow (DCF) method that uses current values to measure the value of future cash flows. The NPV rule is to invest in projects with positive NPVs, and to avoid investing in projects with negative NPVs.
How to Calculate the Net Present Value of an Investment?
The NPV calculation is one method of comparing the expected return on a project with the expected cost. It is generally used to decide whether to invest in a project, but it is also used for investment appraisal.
NPV calculation also can be used to compare the expected return on a project with the expected cost when there is no option to invest, and that is where the name comes from. That’s because the NPV is the same as the NPV of the only investment.
Example of NPV Calculation
Watson manufacturing has an opportunity to invest $96,000 in a new machine. The new machine will result in cost savings of $25,000 in year 1, $25,000 in year 2, $25,000 in year 3, $25,000 in year 4, and $25,000 in year 5.
The new machine will require a tune-up in year 3, costing $3,000. The salvage value of the machine will be $10,000 at the end of year 5. Watson’s cost of capital is 10%. Create a table showing the cash flows in each year of the project and compute the NPV.
|
Year | 0 | 1 | 2 | 3 | 4 | 5 |
|
Outflows | (96000) |
(3000) | ||||
|
Inflows | 25000 | 25000 | 25000 | 25000 |
35000 | |
|
Net CF | (96000) | 25000 | 25000 | 22000 | 25000 |
35000 |
|
Dis. factor | 1 | 0.909 | 0.826 | 0.751 | 0.683 |
0.621 |
| (96000) | 22,725 | 20650 | 16522 | 17075 |
21735 |
NPV = 22725+20650+16522+17075+21735 – 96000 = $2707
The NPV is: $2707, hence the investment acceptable.
